Whether you’re an executive at a big company or a new investor, it’s important to know about dividends, and how to calculate the dividend payout ratio.
A dividend is a portion of the company’s profit that they give back to investors. Dividends can be reinvested, helping investors maximize their returns over time. Knowing what to expect from one’s investments when dividends are paid out can be helpful when devising a strategy.
Learning how to calculate dividend payout ratio is easier than investors might expect. Before learning to use and calculate the dividend payout ratio formula, it’s important to understand how dividends work and what ratios are.
What is the Dividend Payout Ratio?
Dividends are small cash payments made to a company’s shareholders. In effect, a company takes a portion of its quarterly profits, divides it up among its shareholders, and pays it out in the form of dividends. The remainder is reinvested back into the business.
If an investor owns a stock or fund that pays dividends, they can expect a small payment from that company quarterly—roughly once every three months. The actual dividend payout ratio that shareholders receive varies wildly, and depends on the individual stock or company in question. But generally speaking, a 15% or 5% payout ratio, as calculated above, would be considered pretty low. Average payout ratios tend to be closer to 40%.
A dividend payout ratio is a comparison between a company’s profits and its dividend payout. When a company reports earnings, it also reports its total profits for the time period (usually a quarter). From those profits, a company will pay out dividends. If a company’s total profits were $100, and its dividend is $1, the dividend payout ratio would be 100:1.
In finance, ratios are pretty common. While the focus here is on dividend payout ratios, another common one is the price-to-earnings ratio, which is a comparison of a company’s share price to its earnings per share.
The Dividend Payout Ratio Formula
There are a few ways to calculate the dividend payout ratio. But probably the simplest method is to divide the total dividends paid out over a year (the sum of four quarters) and divide it by the net income, or earnings, during the same period.
To calculate a dividend payout ratio, the equation looks like this:
Dividends paid / Net income
There are other calculations that can also determine the ratio. For example, an alternative formula uses dividends per share and earnings per share as variables:
Dividends per share / Earnings per share
A third formula loops in a retention ratio, which tells us how much of a company’s profits are being retained for reinvestment, rather than paid out in dividends. Here’s the formula for the retention ratio:
Net income – Dividends paid / Net income
Then, the dividend payout ratio can be calculated by subtracting the retention ratio from one:
Dividend payout ratio = 1 – Retention ratio
For simplicity’s sake, it’s probably easiest to stick to the first formula. That’s because the only variables needed to conduct the operation are the total dividends paid and a company’s net income. Both of those variables should be relatively easy to find in a company’s financial statements, like an earnings report or annual report.
How to Calculate the Dividend Payout Ratio
Here’s an example of how to calculate the dividend payout ratio: Company X releases its annual report that shows earnings of $100 for the year, and that it issued $15 to shareholders in the form of dividends. Those are the two variables needed to calculate the dividend payout ratio: simply divide the total dividends paid by the total earnings:
15 / 100 = 0.15, or 15%
The dividend payout ratio in this example is 15%. That means that 85% of Company X’s earnings for the year were retained and reinvested by the company, while 15% of its earnings were returned to shareholders in the form of dividends.
Here’s another example: Company Z reports that it generated $6 billion in earnings during the year 2019. Also during that year, the company paid out $300 million in dividends to shareholders. Here’s what the formula would look like:
300,000,000 / 6,000,000,000 = 0.5, or 5%
While both of these examples are hypothetical, they are both useful in understanding how the dividend payout ratio is calculated.
Using Dividends as a Part of an Investing Strategy
A dividend payout ratio gives investors more insight into the health of a company. And there are some insights to be learned depending on how high or low the ratio is.
For instance, if the ratio is high—a company pays out relatively high dividends—that may be a sign that a company is established, or not necessarily looking to expand in the near future. Lower ratios can mean the opposite; a company retaining a higher percentage of its earnings may need that money to invest and expand its operations.
For investors, though, dividends are one of the primary ways that their holdings earn them money. Some investors choose to invest in stocks or funds that traditionally pay out high dividends, and often (sometimes monthly). These are often called “dividend stocks,” for obvious reasons. Investors can often choose to automatically reinvest the dividends they do earn, increasing the size of their holdings, and therefore, potentially earning even more dividends over time.
That can be a good strategy for investors looking for ways to generate passive income, and to earn returns from their investments despite market conditions. But it’s important to keep in mind that companies can and do cut or suspend their dividends , which can throw a wrench in an investor’s strategy. There are also tax implications to consider, as investors do owe taxes on income generated via dividends.
The dividend payout ratio formula is fairly straightforward: divide the company’s net income by the dividends paid. That ratio can give an investor insight into a company, and also help them decide if or how dividends fit into their overall strategy.
As a part of a strategy, investing in dividend stocks may be a way to grow a portfolio with less risk. But those stocks aren’t generally likely to increase in value at the same rate as stocks with lower dividend ratios. Knowing the role dividends play in a particular stock can be helpful in making informed decisions.
Dividends can be particularly attractive bonuses for some investors. SoFi Invest® offers weekly dividends, which gives investors flexibility in folding those dividends into their overall strategy, potentially boosting their saving and investing habits.
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